The '1994 Moment' Is Keeping More And More Bond Traders Awake At Night

Bloomberg, @fullcarry, Business Insider
The pickup in the economic data in the U.S. lately and the Federal Reserve's recent musings on tightening monetary policy have many wondering if bond markets are set to repeat a "1994 scenario."

In 1994, the economy was emerging from a big recession, and Treasury yields began to rise slightly from their 1993 lows as the growth outlook improved - though no other signs of inflation had yet emerged.

Taking their cue from rising yields, Alan Greenspan and the Fed surprised markets by beginning to tighten monetary policy, and Treasuries plunged as interest rates screamed higher throughout the year.

Given the recent rise in Treasury yields after a sustained period at low levels - the same impetus for the Fed's tightening in 1994 - many wonder if the stage is set for another bloodbath in fixed income markets.

One experienced bond trader who got his start in 1993 sent us the chart above, annotated with an arrow and the comment, "We could be here."

The year is 1994. Bill Clinton is in the White House, Alan Greenspan presides over the Federal Reserve, and the U.S. economy is finally starting to recover from a big downturn

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The economy had plunged into recession following the savings and loan crisis of the late 1980s. The ensuing recovery has had its ups and downs, but by Q1 1994, economic growth is finally starting to surge

Bloomberg, Business Insider

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For the past year and a half, the Fed has held interest rates stable around 3 percent after a multi-year easing period following the crash

Bloomberg, Business Insider

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Naturally, with the economy now booming and interest rates pinned at low levels, the stock market is on fire

Bloomberg, Business Insider

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Meanwhile, at 2.5 percent, inflation is at its lowest level in years, while unemployment is still above pre-recession levels

Bloomberg, Business Insider

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Nonetheless, Treasury yields have reversed course and risen sharply since late in 1993 as the bond markets anticipate inflation caused by the booming economy

Fast forward to 2013. What are people saying today?

BofA investment strategist Michael Hartnett warns of a repeat of the "1994 moment"

The current level of US jobless claims (335K) is the lowest since Jan 2008, when the unemployment rate was just 5.0%. If the global economy and corporate animal spirits revive sufficiently to cause an upward surprise to US payroll numbers in coming months, say numbers in excess of 300K, then a repeat of the 1994 "bond shock" is likely.

In recent months we've drawn a number of comparisons to market returns in 2012 and 1993, the last year banks assumed major global leadership. In 1994 the combination of stronger-than-expected payroll, a tighter Fed, a 200bps back-up in yields led to a big pause in the nascent equity bull market and a savage reversal of fortune in leveraged areas of the fixed income markets (e.g. Orange County & Mexico).

Investors banking on economic recovery should therefore be reducing longs positions in High Yield and EM debt.